Progressive Consumption Taxes

Hastings Law Journal

Volume 57 | Issue 1

Article 2

1-2005

Progressive Consumption Taxes

Mitchell L. Engler

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MITCHELL

L. ENGLER*

INTRODUCTION

Consumption taxation recently has taken center stage as an enticing,

and realistic, possibility at the federal level. After years of debate, an

academic consensus has emerged that favors the consumption tax,'

especially as it would close significant loopholes under the income tax.'

The consumption tax's political prospects have increased along with its

burgeoning intellectual appeal. The Bush Administration, armed with

enhanced Republican Congressional control, has made fundamental tax

reform a second-term priority,' and the Administration has a known

affinity for the consumption tax.

As intellectual and political forces move the consumption tax to the

forefront, critical issues remain. A conventional retail sales or

value-added tax (VAT) eliminates the current progressive rate structure,

raising persistent distributional objections.' In hopes of achieving the

* Professor of Law, Benjamin N. Cardozo School of Law, Yeshiva University. I am grateful to Reuven Avi-Yonah, David Carlson, Arthur Jacobson, Kyle Logue, Ed Zelinsky, and all the participants at the University of Michigan Law School Tax Policy Workshop for their helpful comments. I would also like to thank Michael Giusto, Julia Rubin and Mark Schwed for their valuable research assistance.

I. Joseph Bankman, The Engler-Knoll Consumption Tax Proposal: What Transition Rule Does

Fairness (or Politics) Require?, 56 SMU L. REv. 83, 83 (2003).

2. This involves unintended structural loopholes, not intended special preferences such as deductions for home mortgage interest. As discussed infra note 82 and accompanying text, such intended preferences could be maintained under a consumption tax.

3. Nancy Ognanovich, Bush Wraps Up Summit with Pledge to Push Agenda Hard in Congress,

DAILY TAX REP. (BNA), Dec. 17, 2004, at G-i, G-2 ("Bush reiterated that he plans to use his considerable political capital to push for his agenda [including tax reform] in Congress, where the Republican party has expanded its majority status."). President Bush established a bipartisan Advisory Panel on Federal Tax Reform on January 7, 2005. The panel was charged with recommending ways to enhance the fairness, simplicity, and efficiency of the tax code. Several delays prevented the Panel from issuing its report before the publication deadline for this Article. See, e.g., Tax Reform Panel Postpones Meetings, TAX NOTES, Sept. 7, 2005, available at LEXIS 2005 TNT 173-28.

4. Nancy Ognanovich, Bush Says He Will Begin Difficult Effort To Change Tax, Social Security

Structures, DAILY TAX REP. (BNA), Nov. 5, 2004, at GG-I (Treasury Dept. has looked at a "number of consumption-based taxes" during Bush's first term).

5. The first change-shifting the tax base from income to consumption-has also raised distributional objections due to a perceived elimination of the tax on investment returns. This

HASTINGS LAW JOURNAL

consumption tax benefits without sacrificing individualized progressivity,

scholars have increasingly responded with innovative proposals. Two

such proposals-the "X-tax" and the "Hybrid Approach"-were

separately analyzed in an important "fundamental tax reform"

symposium of distinguished tax policy experts. Unlike traditional

consumption tax models, both proposals would tax individuals on their

wages, even if saved. In recognition that wages deviate from actual

consumption, both "dual" consumption taxes would supplement the

wage tax with a second tax. The Hybrid Approach, which I originally

proposed,

7

would also tax individuals on the excess of (i) savings

withdrawals for consumption over (ii) previously-saved wages plus the

risk-free interest return thereon. The X-tax, originally proposed by

Professor Bradford,

8

would impose a VAT-like tax on businesses,

modified to allow a wage deduction.

By further analyzing and showcasing these two inventive ways to tax

consumption with individualized progressivity, the recent symposium

significantly furthered the progressive consumption tax cause. Yet, the

separate analyses of these two independent proposals missed an

opportunity for even greater advancement. The proposals' striking

overlap amidst their obvious differences cries out for further

comparative analysis. On the one hand, the shared characteristics of the

two proposals highlight the merits of breaking the consumption tax into

multiple parts, with a progressive wage tax as the first part. Beyond such

considerable overlap, however, a critical comparative issue arises

regarding the best supplementary tax for the wage tax. Should it be a

VAT-like tax on businesses, like the X-tax suggests, or should individuals

be taxed on savings withdrawals less previously-saved wages, like the

Hybrid Approach proposes?

This Article undertakes the much needed comparative analysis and

identifies the significant advantages of each approach. By limiting

individual reporting to wages, the X-tax has certain administrative

advantages over the Hybrid Approach. On the other hand, the X-tax

objection has decreased in importance, though, as recent scholarship demonstrates flaws in such

perception. See infra Part I.A.

6. Leading tax academics and practitioners contributed articles to the SMU Law Review symposium edition on fundamental tax reform. Symposium, Incremental and Fundamental Tax

Reform, 56 SMU L. REV. I (2003). Professor David Weisbach analyzed the X-tax. David A. Weisbach,

Does the X-tax Mark the Spot?, 56 SMU L. REV. 201 (2003). Professor Michael Knoll and I analyzed

the Hybrid approach, with a commentary by Professor Joseph Bankman. Bankman, supra note i; Mitchell L. Engler & Michael S. Knoll, Simplifying the Transition to a (Progressive) Consumption Tax,

56 SMU L. REV. 53 (2003).

7. Mitchell L. Engler, A Progressive Consumption Tax for Individuals: An Alternative Hybrid

Approach, 54 ALA. L. REv. 1205 (2003).

8. David F. Bradford, What are Consumption Taxes and Who Pays Them?, TAX NoTEs, Apr. i8,

1988, at 383, available at LEXIS 39 TAX NOTES 383.

would change current law significantly more than the Hybrid Approach,

changes which are unnecessary in the move to a consumption tax. For

instance, the X-tax would move the tax on "pass-through" tax

partnerships from the partners to the partnership itself;

9

more generally,

individuals would pay tax only on "wages." These and other X-tax

changes exacerbate transition concerns and are more likely to trigger the

related "status quo bias" against substantial changes. In favorable

contrast, the Hybrid Approach largely preserves the current framework

while shifting to a tax on consumption.

Is it possible, then, to harmonize the respective strengths of the two

proposals and craft a progressive consumption tax which minimizes both

administrative concerns and ancillary changes? Refining my original

Hybrid Approach, I now propose a new consumption tax which

supplements the wage tax with

(I)

a corporate business tax and

(2)

a

narrowed individual tax on investments which exempts the following

from individual reporting: most corporate stock, bank deposits, treasury

securities, and comparable low-rate interest investments.

Part I evaluates the recent trends underlying the consumption tax's

growing support, including loophole proliferation under our current

income tax system and a better understanding of how income and

consumption taxes comparatively burden investment returns. Part II

highlights the shortcomings of the traditional VAT and other

"single-element" consumption taxes. Part III demonstrates how the shared dual

elements of the X-tax and Hybrid Approach respond to these

shortcomings. Part IV identifies key differences between the X-tax and

Hybrid Approach. Part V develops the new proposal, demonstrating its

superiority over the other leading options and current law.

I.

THE EMERGING CONSUMPTION TAX CASE

The income versus consumption tax debate has long centered on the

merits of taxing investment returns, following the traditional belief that a

consumption tax exempts all investment return relative to an income tax.

Consumption tax proponents typically argued that the income tax

burden on investments resulted in too little savings. Income tax

proponents typically countered on fairness grounds: i.e., the wealthy

would disproportionately benefit from the consumption tax's exemption

of investment income.

Two recent trends have shifted the analysis, though, and drive the

consumption tax's accelerating support. First, commentators have

exposed serious flaws in the traditional belief that the consumption tax

exempts all investment returns relative to a loophole-free income tax.

Recent commentary shows instead that a consumption tax comparatively

HASTINGS LAW JOURNAL

exempts only the low risk-free return.'" Part L.A provides a new

demonstration supporting these claims. Second, income tax shelters

continue to proliferate despite complicated anti-avoidance rules, thereby

exposing intractable structural problems with the income tax." The

consumption tax effectively, and simply, corrects the core income tax

defect, as shown in Part I.B. A consumption tax therefore appeals

independent of the national savings concern because it would close

income tax loopholes while yielding relatively little of the tax base.'

2

A.

LIMITED RISK-FREE EXEMPTION UNDER THE CONSUMPTION TAX

What

explains

the

long-standing

misconception

that

the

consumption tax exempts all investment return compared to an income

tax?'

3

A subtle, but flawed, assumption regarding investment decisions

provides the answer. The misconception implicitly assumes that savers

would increase their risky investments with the additional funds available

to them prior to consumption under a consumption tax.'

4

As evidenced

by the first example below, savers appear to "avoid" tax on their

profitable investments under this assumption, because the extra pretax

return from the increased investments equals the tax on all the

investment returns. By focusing solely on the upside, the traditional view

disregards the greater downside risk of loss from increased risky

investments, as evidenced by the second and third examples.

Assume taxpayer (T) earns a

$ioo,ooo

salary in 2004, payable on

12/31/04.

T saves the entire salary for consumption one year later on

12/31/05."

T invests all after-tax wages in X Corporation stock. The X

Io. E.g., Noel B. Cunningham, The Taxation of Capital Income and the Choice of Tax Base, 52 TAX L. REV. 17 (1996); Alvin C. Warren, Jr., How Much Capital Income Taxed Under an Income Tax Is Exempt Under a Cash Flow Tax?, 52 TAX L. REv. 1, I6 (1996). The real risk-free rate has been quite low over time, with the short-term rate averaging about o.5% over a recent sixty-year period. Joseph Bankman & Thomas Griffith, Is the Debate Between an Income Tax and a Consumption Tax a Debate

about Risk? Does it Matter?, 47 TAx L. REv. 377, 387-90 (1992). The figure is somewhat higher for long-term debt. The real, rather than the nominal, risk-free return is appropriate given the general agreement that even an income tax should exempt the inflationary component of investment return.

See Barbara H. Fried, Fairness and the Consumption Tax, 44 STAN. L. REV. 961, 985 (1992).

i i. Some have labeled the current system a hybrid income/consumption tax because it has some consumption elements (e.g., the treatment of qualified retirement savings). E.g., Edward J. McCaffery,

Tax Policy Under a Hybrid Income-Consumption Tax, 70 TEx. L. REv. 1145, 1146 (1992). This

discussion nonetheless refers to the current system as an "income tax," consistent with its historical label and underlying core structure.

12. This concern over savings might, of course, lend additional support to the consumption tax.

13. See Joseph Bankman & Barbara H. Fried, Winners and Losers in the Shift to a Consumption

Tax, 86 GEO. L.J. 539, 541 (1998) ("[Mlost legal commentators have traditionally assumed that shifting from an income to a consumption tax would affect all returns [by] moving them in each case from a positive to zero rate of tax. Over the last 15 years, commentators have chipped away at the standard analysis of a consumption tax as repealing the existing (positive) tax on all [investment returns].").

14. Additional funds are available because a conventional consumption tax defers the tax on saved wages until consumption.

i5. Such extreme savings of too% is considered for ease of exposition. The demonstrated [Vol. 57:55

stock doubles in value over the one-year investment period. A flat 40%

tax rate applies under either the income tax or the consumption tax.'

6

Example i begins by highlighting the source of the misconception

regarding taxation of risky returns.

Example IA (Income Tax Results): Under a 40% income tax rate, T

owes

$40,000

tax in

2004

on $ioo,ooo of wages.

7

T invests the

remaining $6o,oo0 in X Corporation stock. The stock investment is sold

on December

31, 2005

for

$120,ooo.

T reports a

$6o,oo0

stock gain,

resulting in a $24,000 tax liability. This leaves $96,ooo of after-tax funds

available for consumption.

Example iB (Consumption Tax Results): To facilitate the comparison

to the income tax, consider the cash flow version of the consumption

tax. The cash flow tax converts the current income tax into a

consumption tax through two primary adjustments:

8

(i) an unlimited

deduction of new savings,

I

" and (ii) the inclusion of savings withdrawals

for consumption. Under such a cash flow (consumption) tax, T owes no

tax in 2004. T invests $ioo,ooo of wages in X Corporation stock, which

is sold one year later for $200,000.

2°

T owes total tax of $8o,ooo on the

$200,000

"savings withdrawals," leaving

$120,000

of after-tax funds

available for consumption."

The old view that a consumption tax comparatively exempts all

investment return appears in three different ways from the Example I

results, tabulated as follows:

Income Tax

Consumption Tax

12/31/04

Investment

$6o,ooo

$I00,ooo

2005

Profits

$6o,ooo

$Ioo,ooo

12/31/05

Pretax Funds

$120,000 $200,000

2005

Total Tax

$24,00022 $8o,0023

12/3 1/05

After-Tax Funds

$96,000

$120,000

principles remain applicable where T saves less than all his salary.

16. A flat tax rate is assumed for ease of exposition in developing the initial key principles.

17. Under an income tax, even "saved wages" generally are taxed in the current year. There is a

limited exception for qualified retirement savings that does not apply on these facts. See infra note 163 and accompanying text for a discussion of qualified retirement savings under a consumption tax.

18. In addition, subject to possible exceptions, loan proceeds would increase the tax base while loan repayments would reduce the tax base. For a more detailed discussion of loans, see Engler, supra note 7.

19. Under the current income tax, limited amounts of qualified savings are deductible. See

discussion of retirement savings, infra note 163 and accompanying text.

20. This assumes T earns the same pretax return regardless of the investment amount. See infra

note 35.

2. $200,0oo - (40% X $200,000). 22. 40% x $6o,ooo.

HASTINGS LAW JOURNAL

First, the

2005

after-tax funds under the consumption tax

($120,000)

match the

2005

pretax funds under the income tax, suggesting an implicit

consumption tax exemption for the stock gains.' Similarly, T has

$24,000

of additional after-tax funds in

2005

under the consumption tax

($120,000 -

$96,000),

equal to the full tax on the investment profit under

the income tax. Finally, compare the different pretax stock gains: $60,000

under the income tax versus $ioo,ooo under the consumption tax. The

extra $40,000 pretax profit under the consumption tax equals the total

consumption tax collections on T's $ioo,ooo aggregate investment profit

($I00,000 x 40%).25

Example I masks the real reason for the full "exemption" of the

risky stock gain by considering only a profitable stock investment.

Increasing the risky stock investment from $60,000 to $ioo,ooo exposes T

to greater risk of loss if X stock declines in value.

Example

2

demonstrates this greater loss exposure by assuming that

the X stock experiences a 50% decline in value during

2005.

Example

2A

(Income

Tax

Results): Under

the income tax,

T's $6o,ooo

X

stock

investment is sold for $30,000 on December 31, 2005. T reports

a $30,000 loss on the sale. Such

tax loss

saves T $12,000 tax ($30,000 x

40%), assuming that tax losses are deductible against other taxable income. The stock investment therefore increases T's after-tax funds available for consumption in 2005 by $42,000: $30,000 stock sale proceeds plus a $12,ooo reduction in otherwise payable income taxes.

Example 2B (Consumption Tax Results): Under the cash flow tax, T

sells the $ioo,ooo X stock investment for $50,000 on December 31,

2005. T owes $20,000 tax on the $50,o00 savings withdrawal ($50,000 x

40%). This leaves T with $30,000 after-tax funds available for consumption in 2005.

24. It is an implicit exemption because that tax actually is collected under the cash flow tax on the full investment return.

25. T's total tax bill of $8o,ooo can be divided into a $40,ooo deferred payment on the $ioo,ooo in

wages plus a $40,000 payment on the $ ioo,ooo stock gain. Another way to see the apparent exemption is that this $40,000 tax on the stock gain equals the $16,ooo tax on the additional $40,000 pretax return plus the $24,000 tax on the investment profits under the income tax.

26. This is appropriate under the income tax as the original investment was already subject to tax. The particular form of a real-world income tax might deny the taxpayer the full value from the loss (a "full loss offset"). A smaller decline in loss exposure results, e.g., to the extent losses do not generate (i) current tax savings (i.e., a deduction against other taxable income for the year or a government refund if the loss exceeds other net income for the year), or (ii) future tax savings through a loss carryforward, increased by interest as compensation for deferral. This can arise where limitations are placed on loss deductibility. See, for example, the current rule limiting capital loss deductions to the capital gain income plus $3,000. I.R.C. § 121 i(b) (2000). While unused capital losses carry forward, the

taxpayer does not receive full value from the loss because the carryover loss amount is not increased by an interest factor. In theory, however, an income tax arguably should allow full loss compensation. In fact, the current restrictions must be analyzed in the context of the current income tax which has practical shortcomings, such as the selective loss realization problem discussed infra notes 58-6o and accompanying text.

The additional loss exposure under the consumption tax can be seen in

several ways from the Example

2

results, tabulated as follows:

Income Tax

Consumption Tax

2004

Investment

$6o,ooo

$Ioo,ooo

2005

Pretax Return

($30,000 loss)

($50,000 loss)

2005

Pretax Funds

$30,000

$50,000

2005

Tax or Savings

$12,000

savings"

$20,000'

2005

After-Tax Funds

$42,000 $30,000

Once again, T's

2005

after-tax funds under the consumption tax

match the

2005

pretax funds under the income tax. In this case, however,

T is

$12,ooo

better off under the income tax due to the

$30,000

income

tax loss and the 40% tax rate. The

$12,ooo

difference also can be

determined by focusing on the extra

$20,000

investment loss under the

consumption tax. T bears 6o% of this additional pretax loss because the

government bears a percentage of T's losses equal to the tax rate under

either the consumption or income tax."

So how much of the full investment return "exemption" in Example

i was attributable to the additional risk of loss, rather than the shift to a

consumption tax? After equating T's risk of loss under the income and

consumption taxes, Example 3 below demonstrates the new view that the

consumption tax exempts only the risk-free return.

Assume now that T invests the additional $40,000 available to him

on December

31, 2004

under the consumption tax in a risk-free Treasury

note, which pays interest at an assumed io% risk-free rate. T invests the

other $6o,ooo in the risky X stock. Tracking Examples i and

2,

assume, in

the alternative, that the X stock either doubles in value or declines by

50%.

27. 40% x $30,ooo. This assumes the $30,0oo tax loss (i) offsets other taxable income for the

current year, (ii) losses carry forward with an interest adjustment, or (iii) the government provides a current refund for net losses in the current year. See supra note 26.

28. 40% x $5o,ooo.

29. Loss sharing results under the cash flow tax because pretax losses reduce savings available for withdrawal, which are subject to tax. Loss sharing results under the income tax because taxpayers report gain or loss based on the difference between purchase and sales prices. The following proof .hows the equivalency of the two textual explanations of the $12,ooo difference. The first way-simply the loss under the income tax times the tax rate-can be expressed as L x TR. The second explanation takes the product of (i) one minus the tax rate and (2) the additional pretax loss, which equals the excess of (i) the product of the income tax loss, and one divided by one minus the tax rate (because that equals the amount by which T increased the stock investment) over (ii) the income tax loss. This can be expressed as (i -TR) x ([L x i/(i -TR)] - Ll. This expression becomes (i - TR) x ([L/(i

HASTINGS LAW JOURNAL [Vol. 57:55

Example 3A (X Stock Doubles): The Treasury note pays $44,000 one

year later ($40,000 plus $4,000 interest). Assuming the X stock doubles

in value, T sells it for $i2o,ooo on December 31, 2005. T has total funds

of $164,ooo before taxes. After paying the 40% cash flow tax, T has

$98,400 available for consumption on December 31, 2005.30

Example

B (X Stock Declines by So%): Assuming the X stock

declines by 50%, T sells it for $30,000 on December 31, 2005. T has

total funds of $74,000 before taxes ($30,000 stock sale proceeds plus

the $44,000 treasury note proceeds above). After paying the 40% cash

flow tax, T has $44,400 available for consumption on December 31,

2005.3'

The 2005 after-tax funds from all three examples, tabulated below,

support the new view that a consumption tax comparatively exempts

only the risk-free return.

Income Tax

Cash Flow Tax:

Cash Flow Tax:

New View

Old View

100%

stock increase

$96,000

$98,400

$120,000

50% decline in stock

$42,000

$44,400

$30,000

Under the new view, the consumption tax increases T's after-tax

funds by a narrow, and constant, amount of $2,400 (compare the second

and third columns). This contrasts favorably to the old view, which leaves

T with significantly more or less after-tax funds depending on the stock's

performance (compare the second and fourth columns). The new view's

superiority is based on its sounder assumption of equal tolerance for

stock market losses under the alternate tax structures.

32

The steady

$2,400 difference under the new view also quantifies the consumption

tax's limited risk-free exemption. The $2,400 excess under the

30. 40% x $164,000 = $65,6oo. $64,000 - $65,6oo = $98,400. 31. 40% x $74,ooo = $29,6oo. $74,0oo - $29,6oo = $44,4o0.

32. This is suggested by the fact that T is $54,ooo worse off under both the second and third columns if X stock declines by 50% rather than doubling in value. This does not properly quantify the true risk of loss, of course, because this compares one loss scenario to one positive return possibility. A better comparison would contrast the 5o% stock decline scenario to an alternative under which T invested all funds in risk-free treasury notes yielding io%. If so, T would have had (i) $66,ooo under the consumption tax ($iio,ooo Treasury Note proceeds less $44,ooo tax thereon) and (2) $63,6oo under the income tax ($66,ooo Treasury Note proceeds less 4o% tax times the $6,ooo interest return). Thus, T loses a steady $21,6oo under either the income tax or the consumption tax if T invests $6o,ooo in the stock under both taxes ($63,6oo - $42,ooo under the income tax; $66,ooo - $44,4oo under the consumption tax). In contrast, T loses $36,ooo if T increases his risky stock investment to $ioo,ooo under the consumption tax ($66,ooo - $3o,ooo).

One difference between the income and consumption taxes should be noted: T receives an additional risk-free return under the consumption tax, which might have an impact on T's investment decisions. Nonetheless, the new view does seem to make a sounder assumption than the old view, even taking into account such difference.

consumption tax equals the tax rate times only the risk-free return on the

saved wages under the income tax (40% x io% x $6o,ooo).

33

Accordingly,

risky investment returns would not become exempt by virtue of a shift to

the consumption tax.

34

Finally, the above analysis generally holds true even if T invested the

full $ioo,ooo wages in the risky stock under the consumption tax. If so, T

similarly should, and could, increase the riskiness of his portfolio under

the income tax given this higher risk tolerance." This could be done by,

33. A conceptual explanation for the consumption tax's limited risk-free exemption follows. The cash flow tax differs from the income tax in that taxpayers retain until consumption the tax on saved wages; this equals the tax rate times the pretax saved wages ("TR x SW"). Taxpayers should make similar risky investments under the income and consumption taxes because, in either case, they share gains and losses with the government. This assumes the same, constant tax rate under the income and consumption taxes and, as discussed infra note 26, a theoretically-sound full loss offset under the income tax. The cash flow benefit from tax deferral on saved wages therefore equals the risk-free return ("RFR") on the deferred tax because taxpayers generally should invest it in risk-free assets: RFR x TR x SW. As suggested infra note 35 and accompanying text, taxpayers should use the extra cash to purchase risky assets in certain cases, but this does not change the general analysis. The RFR x TR x SW pretax return must be reduced because such return will be taxed when withdrawn for consumption, leaving: RFR x TR x SW x (i - TR). Reordered as TR x RFR x (i - TR) x SW, taxpayers "avoid" tax on the risk-free return generated by the after-tax saved wages. This assumes the same rate applies to wages and the risky returns. The calculation changes if a lower rate applies to the risky returns under the income tax (e.g., a lower capital gains tax). If so, the difference between the income and the consumption tax narrows because the taxpayer should invest less in the risky asset under the income tax than under the consumption tax. This results because the taxpayer has to share less of the risky profits with the government under the income tax's lower risky rate. See David A. Weisbach, Taxation and Risk-Taking with Multiple Tax Rates, 57 NAT'L TAX J. 229 (2004) (providing formula for calculating such reduction).

34. This is not to say that a consumption tax necessarily burdens risky investment returns. As discussed below, investors might be able to avoid the burden by increasing their investment amounts. This would not be a new or relative exemption under the consumption tax as a similar possibility exists under the income tax. See infra note 35.

35. This possibility of increased risky investments under either the consumption or income tax explains the recent commentary that both income and consumption taxes exempt certain risky returns.

See, e.g., Cunningham, supra note to. The argument follows from the concept that the government

shares both gains and losses with taxpayers in a percentage equal to the tax rate. If so, taxpayers arguably can negate the risky investment return by increasing the risky investments by a factor equal to one divided by one minus the tax rate. Consider again the basic facts of Example i but now assume a stand-alone wage tax which expressly exempts investment returns. T owes $40,000 tax on 12/31/04, leaving $6o,ooo to invest in X stock. If the stock doubles in value, T is left with $I2o,ooo for consumption. As evidenced by Example iB, T achieves the same result if he makes a $ioo,ooo stock investment with the $ioo,ooo available funds. While T formally paid tax on both the $ioo,ooo wages and the $ioo,ooo investment return, a comparison to the stand-alone wage tax evidences the lack of any burden on the risky return. Restated, T should be comfortable making such increased investment under the consumption tax-relative to the wage tax with the investment return exemption- because the government bears 40% of T's loss under the consumption, but not the stand-alone wage tax. On the positive side, increasing the investment amount by i/(i - t) "avoids" the tax because T keeps

(i -t) x P after taxes where t equals the tax rate and P equals the pretax profits. This argument requires certain assumptions such as constant tax rates and the lack of market pricing changes if investors increase their investment amounts in this fashion. The merits of the assumptions, and hence the argument regarding the risky return exemption, need not be resolved for purposes of the consumption/income tax debate. This results because the income and consumption taxes generally

HASTINGS LAW JOURNAL

e.g., (i) liquidating risk-free assets, if any, to purchase more

X

stock;

(2)

purchasing even riskier investments with the $6o,ooo after-tax saved

wages; or (3) using leverage to acquire more

X

stock (either options or

regular loans). And the difference between the income and consumption

taxes generally remains limited to the risk-free return even under such

changed facts.

6

B.

CONSUMPTION TAX CORRECTS CORE INCOME TAX DEFECT

The prior demonstration assumed away some long-standing practical

problems under the income tax. This section now considers the

real-world shortcomings of the income tax, which solidify the consumption

tax case. This section demonstrates how the consumption tax simply

corrects the income tax's structural problem.

i.

Realization Defects Under the Income Tax

The income tax problems stem from the "realization" requirement

under which income is reported only when "realized" through a market

transaction like the sale of an asset or payment of a salary.

37

The

realization requirement raises a number of income tax avoidance

opportunities, which fall into three broad categories." First, taxpayers

treat the risky returns the same; the difference generally relates solely to the risk-free return. This can be seen from the income tax calculation in note 36, demonstrating how T could boost his after-tax funds to $si7,6oo by similarly making a $Sioo,ooo stock investment under the income tax (e.g., by borrowing funds). The difference between the income and consumption taxes therefore is limited to only $2,400, which equals only the risk-free return. See supra text accompanying note 33.

36. Recall for example the consumption tax results of Example iB where T invested the full $iooooo in the risky X stock which doubled in value. T ended up with $i2o,ooo after-tax funds for consumption. Now assume T similarly purchased $ioo,ooo worth of X stock under the income tax by, e.g., borrowing $40,ooo at the io% risk-free rate. If so, T's after-tax consumption would be $117,6oo

($200,ooo sales proceeds- [$44,ooo debt repayment + $38,400 tax bill (40% x $96,000 profit: $ ioo,ooo stock gain less $4,000 interest expense)]). This once again is $2,4oo less than the consumption tax results. The difference between the income and cash flow (consumption) tax would increase somewhat if T incurred borrowing costs in excess of the risk-free rate. The general analysis nonetheless holds for the following reasons: First, as suggested in the text, taxpayers might be able to increase their risky investments without incurring borrowing costs in excess of the risk-free rate (through options, liquidation of risk-free assets, purchase of riskier stocks, etc.). Second, certain unconventional consumption tax forms-such as the dual Hybrid Approach analyzed infra Part III.A.s-also collect tax on saved wages at the wage date, leaving taxpayers in the same position as under the income tax regarding available investment funds. Finally, even in the limited cases where T would have to incur excess borrowing costs under the income tax, the basic point regarding T's ability to increase his portfolio's riskiness under the income tax significantly undercuts the old view that the consumption tax comparatively exempts the full risky return. For a deeper discussion of these issues, see Engler, supra note 7; Daniel N. Shaviro, Replacing the Income Tar with a Progressive Consumption Tax, TAX NoTEs, Apr. 5, 2004, at 91, available at LEXIS 2004 TNT 66-48.

37. E.g., I.R.C. § ioo (2000) ("[T]he gain from the sale or other disposition of property shall be the amount realized therefrom over the adjusted basis") (emphasis added). There are some limited exceptions under the current structure which apply only in specific designated areas. See, e.g., I.R.C. § 475 (requiring securities dealers to report market appreciation even on retained securities).

38. For a discussion of difficulties with an alternate accretion-based income tax, see infra notes 62-63 and accompanying text (legitimate valuation and administrative reasons underlie the realization

can defer their taxes without interest by delaying realization. As

evidenced by Example 4, this reduces the tax burden under time value of

money principles.

39

Assume T purchased Z stock for $ioo,ooo on

1/1/04

and it

appreciates in value to $200,000 as of 12/31/04.4' T contemplates selling

the stock on

12/31/04

and reinvesting the

$200,000

in Y Corp. stock. T

will consume all after-tax proceeds one year later on

12/31/05.

The Z and

Y stocks both double in value during 2005.' Assume the income tax

applies a flat 40% rate to all income, including capital gains.

4

" T holds

$40,000 of cash which will be used to pay the tax if the Z stock is sold on

12/31/04;

if T retains the Z stock until 2005, the $40,000 will be invested

in a io% one-year Treasury note.

43

How much after-tax consumption will

T have, first if he sells the Z stock for reinvestment on

12/31/04,

and

second if he holds the Z stock until consumption on

12/31/05?

Example 4A (Sells for Reinvestment): T owes $40,000 tax in

2004

if he

sells the Z stock for a profit of $ioo,ooo. If T sells the Y stock for

400,000 on 12/31/05, T owes $8o,ooo tax on the $200,000 Y stock gain.

This leaves

$320,000

for consumption.

Example 4B (Holds Until Consumption): T receives pretax proceeds of

$444,000 on 12/31/05: $400,000 from the Z stock and $44,000 from the Treasury Note. T reports $304,000 of income: $300,000 from the Z

stock and $4,000 from the Treasury Note. After paying the tax of

$121,6oo, T has $322,400 for consumption.

What should we make of the

$2,400

difference? At the outset,

consider two conceptual explanations for the different results. As

evidenced by the same $2,400 difference seen above in Section A, T

effectively converted the income tax into a consumption tax by deferring

realization until consumption. As such, T avoided the tax on the risk-free

requirement).

39. Deferral of taxes without interest lowers the true cost because a lesser figure can be set aside today to meet the (future) tax liability; i.e., the lesser figure can be invested and earn interest. The tax system imposes a deferral charge only in very limited circumstances. A more comprehensive interest charge regime has proven elusive despite the efforts of many commentators. See Edward A. Zelinsky,

For Realization: Income Taxation, Sectoral Accretionism and the Virtue of Attainable Virtues, 19 CARDOZO L. REV. 861 (1997). Compare the discussion infra notes 62-63 and accompanying text regarding the elusiveness of a comprehensive regime to eliminate the underlying realization requirement itself.

40. This simplifying assumption establishes the entire $ioo,ooo proceeds as taxable amounts, easing the calculations.

41. Any assumed change in value would demonstrate the principles so long as the Z and Y stocks

experience the same value change. This is required to preserve the pretax equivalency.

42. Accordingly, ignore a possible lower capital gains rate, which is considered infra notes 54-57

and accompanying text.

43. This leaves T with the same amount of risky investments regardless of the timing of the tax payment on the appreciation. This is required in order to maintain pretax equivalency. See supra Part

HASTINGS LAW JOURNAL

investment return.' A more traditional explanation emphasizes T's

ability to defer the tax on the

2004

accrued stock gain without any

interest charge.

45

Given that the basic stock example above might suggest equal

deferral potential for all,

46

why is interest-free deferral until consumption

so problematic? Consider fairness concerns first. Taxpayers in fact do not

have equal deferral opportunities; such opportunities depend on the

nature and amount of their income.

47

Employees, for instance, typically

must pay current tax on their wages even if saved for future

consumption. In contrast, self-employed business owners might achieve

interest-free deferral on their earned income by paying themselves a

below-market salary."

5

And as evidenced by Example 4 above, taxpayers

generally have greater opportunities to defer investment income than

earned income.

49

The end result is that some taxpayers are subject to the

income tax's burden on risk-free savings returns-e.g., the ordinary wage

saver-while others receive the more favorable consumption tax

treatment.

Beyond fairness, interest-free deferral raises deep efficiency

concerns that would exist even if deferral was equally available to all

taxpayers. The realization income tax distorts owners' selling decisions.

Interest-free deferral might induce an owner to retain an otherwise

unwanted asset until consumption, as evidenced by Example 4 above. In

addition, some sophisticated taxpayers transfer the ownership rights

without actual title in hopes of avoiding the tough choice between higher

taxes and unwanted assets. A classic example which worked until

recently is the "short against the box" technique, under which taxpayers

retain their own appreciated shares of stock while selling comparable

shares borrowed from another stockholder." After a well-publicized case

44. Once again, the $2,400 equals the 40% tax rate times the to% risk-free return on the $6o,ooo of after-tax proceeds.

45. E.g., Cynthia Blum, New Role for the Treasury: Charging Interest on Tax Deferral Loans, 25

HARV. J. ON LEGIS. 1 (1988). Under this alternate explanation, T benefits in an amount equal to the product of the deferred $40,000 liability and the 6% (after-tax) interest rate. $40,000 x 6% = $2,400.

46. In other words, all taxpayers have the ability to defer their taxes by avoiding realization until consumption.

47. In particular, the wealthy have greater avoidance opportunities. See infra note 61 and accompanying text. Separately, the disparate tax results can distort behavior, thereby implicating efficiency concerns.

48. This can be done without any economic loss to the owner/employee because the below-market salary increases the value of the stock. For a more detailed example, see Engler, supra note 7, at 1211-12. Sophisticated taxpayers also might defer taxes on wages through a two-step approach: (i) first convert wages to capital gains through leveraged investments, and then (2) use capital losses to offset the capital gains. See Reed Shuldiner, Indexing the Tax Code, 48 TAx L. REV. 537, 646 (1993).

49. Similar to the wage context, deferring realization of investment income provides a benefit equal to the tax rate times the risk-free return on the after-tax investment income.

50. The shareholder effectively locks in the stock gain through this technique because any subsequent losses on the retained shares will be matched by a gain on the short sale.

involving the prominent Lauder family," Congress finally responded with

section

1259

of the Internal Revenue Code which requires gain

recognition upon a "constructive sale of an appreciated financial

position." While section

1259

clearly shut down the short against the box

by specifying it as a "constructive sale,"

5

the underlying problem remains

as more sophisticated approaches are taken in response to the statute

and the provision's limited scope.

53

Distorted selling decisions also contribute to the second category of

realization problems, relating to the lower tax rate for gains on the sale

of a capital asset. Such capital gains preference appeals under the income

tax to reduce "tax lock-in": i.e., the tax bias favoring retention of

appreciated assets.

54

Similar to the deferral analysis above, however, a

different rate for such gains raises equity and efficiency concerns. The

problems go beyond the lower tax paid by those who realize true capital

gains. First, the tax system has difficulty separating the earned income

component from true investment gain in certain areas such as a patent

development. Accordingly, ordinary wages generally will be subject to

ordinary rates while other labor returns will qualify for the capital gains

rate. The broader problem, however, tracks the above deferral analysis.

The significant tax rate difference encourages sophisticated taxpayers to

"convert" ordinary-rate income into long-term capital gains.

6

Once

again, the government has responded with a complicated anti-avoidance

provision that leaves intact the underlying problem.

Tax losses are the third area of vulnerability under the realization

51. Lee Sheppard, Fixes to Ensure That Tax Is Paid on Capital Gains, TAx NOTES, Dec. 5, 1995,

available at LEXIS 1995 TNT 236-5 (The "Lauder family recently dodged more than $ioo million of tax when they cashed out of some of their holdings using a short sale against the box.").

52. I.R.C. § 1259(a)(i), (c)(I)(A) (2ooo).

53. More sophisticated techniques on appreciated stock involve puts and calls. In such cases, the application of section 1259 turns on whether the taxpayer transferred substantially all the benefits and burdens of ownership. See David Schizer, Hedging Under Section 1259, TAX NOTES, July 20, 1998,

available at LEXIS 1998 TNT 138-91.

54. Taxes might encourage individuals to retain assets they would otherwise sell (i.e., in the absence of any tax liability upon sale). Such tax-distorted retention deprives the government of any current tax collections on the gain and also leads to efficiency concerns as transfers to more efficient users might not materialize. For literature analyzing the potential benefits of a reduced rate for gains, see, e.g., Noel Cunningham & Deborah Schenk, The Case for a Capital Gains Preference, 48 TAX L. REV. 319 (1993).

55. See I.R.C. § 1235 ("A transfer of... all substantial rights to a patent.., by any holder shall be considered the sale or exchange of a capital asset held for more than I year ... ").

56. This involves converting wages to investment return. See, e.g., David Cay Johnston, Big

Accounting Firm's Tax Plans Help the Wealthy Conceal Income, N.Y. TIMES, June 20, 2002, at As

(noting wage conversion); Shuldiner, supra note 48. While the tax code has anti-avoidance provisions, they are under-inclusive and add complexity. See infra note 6o.

57. For remaining avoidance possibilities, see, e.g., Shuldiner, supra note 48. For attempted statutory protections, see, e.g., I.R.C. §§ 1258 (recharacterizing gain from certain financial transactions as ordinary income), 163 (limits on interest deductions).

HASTINGS LAW JOURNAL

income tax. Investment losses generally should be deductible under an

income tax because they reduce overall net income." The problem under

a realization income tax is that taxpayers control which assets they sell

each year. Taxpayers therefore can "realize" a tax loss absent a true

economic loss by selling loss assets while retaining appreciated assets.

This allows further interest-free deferral, possibly even beyond the

consumption date.

59

Congress again attempts to police the area with

anti-avoidance provisions, which add complexity without solving the

problem.6

In sum, the realization income tax's interest-free deferral and

preferential capital gains rate raise serious equity concerns given the lack

of equal availability to all taxpayers. The wealthy in particular have

greater access to such beneficial aspects of current law.

6

' Efficiency

concerns similarly abound given the interest-free deferral distortions. As

an aside, an income tax in theory could correct these shortcomings by

dropping the realization doctrine and taxing economic income as it

accrues each year." A number of practical issues block such an

"accretion" income tax, however, most notably administrative and

58. See supra note 26.

59. Consider again Example 4. T deferred the tax on the appreciated Z stock under the realization income tax until consumption by holding the stock until 2005. T might benefit from even longer interest-free deferral under the realization income tax if T held other investments, at least one of which has gone down in value. By selectively selling the loss asset(s) in addition to the Z stock (and reinvesting the proceeds), further interest-free deferral results if such losses can offset the taxable Z stock gain. While government has provided anti-avoidance provisions, sophisticated taxpayers often dodge such obstacles. See infra note 6o.

60. Consider first the more straightforward I.R.C. § 121i(b). This section attempts to protect the earned income tax base from the selective loss problem by allowing capital losses to offset only capital gains plus a de minimis amount of ordinary income ($3,000). Sophisticated taxpayers skirt the limitation by converting earned income to capital gain. See supra note 56. The provision also does not block deductibility against capital gain proceeds which fund consumption. In the other direction, the provision is over-inclusive. Consider for example a taxpayer with $ioo,ooo of earned income who sells his one investment for a $ioo,ooo loss. The taxpayer must pay tax on virtually all the earned income despite the lack of any true net income. See, e.g., Robert H. Scarborough, Risk, Diversification and the

Design of Loss Limitations Under a Realization-Based Income Tax, 48 TAX L. REV. 677 (i993).

More complicated protective provisions include the I.R.C. section 1092 straddle rules. This provision defers realized losses where the taxpayer holds "offsetting positions" with unrealized gains which "substantially diminish" the taxpayers risk of loss. I.R.C § 1o92(c)(2)(A). Taxpayers might avoid the straddle rules, though, by investing in comparable companies. See Daniel Shaviro,

Risk-Based Rules and the Taxation of Capital Income, 50 TAX L. REV. 643, 665-68 (1995).

61. See David Schizer, Frictions as a Constraint on Tax Planning, 101 COLUM. L. REV. 1312, 1315 (2OOI) (government's narrow avoidance provisions have not increased the burden on wealthy

taxpayers, who "sidestep" the provisions); Stephen Joyce, TIGTA Applauds IRS Compliance Scheme,

Urges Better Measurement of Case Closures, DAILY TAX REPORT (BNA), Nov. 29, 2004, at G-4 (A

government audit stated that the "increase in taxpayers earning more than $ioo,ooo annually introduced possibilities of non-compliance because those taxpayers possess the means to engage in tax-avoidance strategies.").

62. This approach would increase (decrease) the tax base by the net increase (decrease) in value of the taxpayer's assets each year.

liquidity concernsi

3

Accordingly, the realization problems continue to

fester after all these years, reinforcing a leading commentator's

characterization years ago of the realization requirement as the "Achilles

heel of the whole comprehensive income tax ideal.

6,

2.

Consumption Tax Addresses Realization Problems

The consumption tax corrects all three problematic areas under the

realization income tax.

65

First, the consumption tax eliminates the tax

incentive to retain appreciated assets until consumption because asset

sales for reinvestment generally would not trigger

tax.

66

Thus, T would

have the same after-tax consumption in Example 4 supra regardless of

whether he sold or held the

Z

stock on December 31,

2004.6

As a related

matter, because tax lock-in would no longer justify the capital gains

preference, the complicated capital gains regime could, and should, be

eliminated under the consumption tax.

68

Finally, the consumption tax

eliminates the tax loss problem because asset sales, even at a loss, would

not reduce the consumption tax base.

69

C. SUMMATION OF CONSUMPTION TAXATION CASE

The consumption tax corrects the interest-free deferral difficulties

under the realization income tax. A consumption tax would raise

potentially significant offsets if, as is sometimes assumed, the

consumption tax exempted all investment return relative to a

loophole-free income tax. The consumption tax comparatively exempts only the

low risk-free return, however, thereby significantly minimizing potential

63. See Zelinsky, supra note 39, at 893-9o1 (describing elusiveness of accretion system and adding public acceptance as another stumbling block).

64. William D. Andrews, The Achilles Heel of the Comprehensive Income Tax, in NEW

DIRECTIONS IN FEDERAL TAX POLICY FOR THE I98OS, at 278, 280-85 (Charles E. Walker & Mark

Bloomfield eds., 1983).

65. See Engler & Knoll, supra note 6; Chris Edwards, A Primer on Replacing the Corporate Income Tax with a Cash-Flow Tax, TAX NOTES, Sept. 8, 2003, available at LEXIS 2003 TNT 174-19.

66. A limited exception exists for purchases of consumer durables (e.g., cars or homes). Such purchases likely would face current tax, notwithstanding an investment element. For a deeper discussion of consumer durables, see Engler & Knoll, supra note 6.

67. T's after-tax consumption would equal $322,400 regardless of whether T sold the Z stock for reinvestment on December 31, 2004. Even if T sold in 2004, T could retain his $40,ooo Treasury Note

investment because he would owe no tax in 2004. This ignores non-tax transaction costs, e.g., broker fees, which are independent of the tax regime.

68. The lock-in justification is generally regarded as the leading justification for the preference.

E.g., Cunningham & Schenk, supra note 54. Note how the new view calls into question another purported rationale in favor of the preference-reducing the tax burden on risky returns. The new view suggests that an income tax does not burden most risky returns. See supra note 35; infra note to9.

69. As discussed supra note 29 and accompanying text, the government shares true economic losses under the consumption tax. Importantly, though, selective sales of loss assets do not reduce the consumption tax base. See Engler & Knoll, supra note 6, at 76 n.Io7 (discussing an alternate escape possibility under the consumption tax involving borrowed funds). As discussed therein, however, the consumption tax significantly narrows the exposed areas, and the consumption tax, unlike the income tax, automatically corrects for time value of money differences.

HASTINGS LAW JOURNAL

tradeoffs to the critical correction of the problematic interest-free

deferral.

7'

Finally, the consumption tax provides

sorely-needed

simplification by eliminating the need for the current complicated

provisions related to interest-free deferral, including the capital gains

regime.

7

'

II.

PROBLEMS WITH "SINGULAR" CONSUMPTION TAXES

The preceding Part demonstrated the significant advantages of

replacing the income tax with a consumption tax. As with any tax law

change, the resulting advantages must be balanced against offsetting

detriments, including transition issues. This Part highlights the significant

offsets under the single-element VAT and the cash flow consumption

tax, which obstruct the shift to a consumption tax.

A.

THE TRADITIONAL

VAT

(AND RETAIL SALES TAX)

The comparable retail sales tax and VAT tax businesses rather than

individual consumers.

7'

Accordingly, tax rates would not vary based on

the consumer's overall consumption level because the tax is based on the

business's operations. Therefore, a VAT would eliminate the current

progressive rate structure, under which individual tax rates increase as

overall income rises. A VAT could impose varying rates on different

goods, e.g., high rates on "luxury" items and low rates on "necessities."

This fails to achieve reliable progressivity, however, as many goods are

consumed by individuals at different wealth levels.

73

In sum, the lack of

individualized progressive rates has raised serious and persistent

distributional objections.

74

Other issues raised by the VAT's

business-70. As discussed supra note 12 and accompanying text, exempting the risk-free return might have substantive appeal as a way to boost national savings. That is, in addition to yielding a relatively minor component of the tax base, such relinquishment might even be desirable in its own right.

71. As discussed supra note 54 and accompanying text, the capital gains relates to interest-free deferral because tax lock-in provides the primary support for the preference. Administrative issues will be discussed in greater detail infra Parts IV.B.I and V.

72. The key difference between the two taxes regards the manner of collection. The VAT collects

the tax on the value added at each level of production. The retail sales tax is imposed on the full retail sales price. The multi-stage VAT is generally viewed as a better check against noncompliance. See Alan Schenk, The Plethora of Consumption Tax Proposals, 33 SAN DIaoo L. REv. 1281 (1996).

73. Varying rates also distort consumer choices by providing a tax incentive to consume more

"necessities" and fewer "luxury" goods.

74. For instance, even leading proponents of a "flat-rate" tax modified the stand-alone VAT to allow some individualized rate variance. See Robert E. Hall & Alvin Rabushka, The Flat Tax: A

Simple Progressive Consumption Tax, in FROrIERS OF TAX REFORM 27 (Michael J. Boskin ed., 1995) (separating out compensation in order to exempt salary of low wage earners); see also Allison Bennet, Bush Soon to Appoint Tax Reform Panel, Committed to Real Change, Bodman Says, DAILY TAX REPORT (BNA), Nov. 19, 2004, at G-8 (Deputy Treasury Secretary Samuel Bodman says the "president wants the tax system to be fair, stressing that 'progressivist is one attribute that is fundamental to fairness in taxation"'); Brett Ferguson, Social Security-Related Tax Reforms "Off the Table," Panel

Chairman Mack Says, DAILY TAX REPORT (BNA), Jan. 31, 2005, at G-8 (Chairman Mack of the

Whitehouse-appointed tax reform panel says the panel "will be sensitive to progressivity"); Nancy [Vol. 57:55

level tax will be reserved for later Parts.

75

B.

CASH FLOW CONSUMPTION TAX

As discussed above, the cash flow tax would convert the current

system to a consumption tax by making two primary changes: (I) an

unlimited deduction for savings, and

(2)

the inclusion of all savings

withdrawals for consumption. In marked contrast to current law,

taxpayers would not pay any tax on saved wages until withdrawn for

consumption.

6

This delayed tax collection on all saved wages implicates

several contentious issues which hinder acceptance of the cash flow tax.

Consider first two interrelated transition issues. Absent special rules,

savings held at transition could be taxed twice. Assume T earns $ioo,ooo

under a 40% income tax. T pays $40,000 tax on receipt, saving the other

$6o,ooo for future

consumption. T withdraws

the $6o,ooo

for

consumption after adoption of a 40% cash flow tax. Under the normal

cash flow rules, T would owe another

$24,000

tax upon such withdrawal.

A special cash flow exemption for previously-taxed savings withdrawals

would address the double taxation. Such transition relief would cause a

significant revenue loss in the early years after the shift, however,

because both newly-saved wages and significant savings withdrawals

would be tax exempt.

77

Ognanovich, Bush Says He Will Begin Difficult Effort To Change Tax, Social Security Structures, DAILY TAx REPORT (BNA), Nov. 5, 2oo4, at GG-i (Bush acknowledges the need for Democratic support for his tax reform agenda); Katherine Stimmel, House Democrats Say They Back Tax Reform

But Not Efforts Toward National Sales Tax, DAILY TAX REPORT (BNA), Nov. to, 2004, at G-5

(Democratic representative James Clyburn favors tax reform but not the "establishment of regressive tax programs," like a national sales tax). A VAT also could achieve progressivity through rebates to less wealthy taxpayers, but this requires a separate determination of every taxpayer's wealth. Cf Laurence Seidman, A Progressive Value Added Tax: Has its Time Finally Come?, TAX NOTES, June 7, 2004, at 1255, available at LEXIS 2004 TNT 110-33 (proposing a low-rate VAT as a supplement to the current income tax, with rebates based on levels of reported income).

75. See infra Part IV.B. Analyzing such other issues is not necessary at this point because lack of progressivity is enough by itself to reject the stand-alone VAT.

76. Under current law's qualified retirement plan treatment, taxpayers can avoid some tax on saved wages. This treatment has significant limitations, however, including (I) ceilings on the amount of saved wages, and (2) prohibitions on use of the savings.

77. The problem is that either the income tax or the cash flow tax by itself generally provides a relatively steady tax flow from savers and dissavers, i.e., those who consume from their savings. The income tax collects from savers while the cash flow tax collects from dissavers. In response to the double tax problem discussed above, assume that after the shift dissavers may consume previously-taxed savings without the usual cash flow tax. The cash flow tax would not collect tax on any new savings-under its regular rules for savings-or any dissavers owning wealth at transition-under the special transition relief. While the problem dissipates over time as dissavers consume their transition wealth, there could be a real decline in tax revenues for some time period. Politics impedes enhanced government borrowing in the interim period as a possible solution. See, e.g. Louis Kaplow, Recovery of

Pre-enactment Basis Under a Consumption Tax, TAX NOTES, Aug. 28, 1995, available at LEXIS 1995

TNT 17 1-47. For a more detailed discussion of these issues, see Engler & Knoll, supra note 6; Engler,

HASTINGS LAW JOURNAL

The cash flow tax also raises more permanent concerns that

taxpayers might not pay the delayed tax on saved wages."' Tax currently

is imposed on saved wages as paid, reinforced by a withholding

obligation on the employer. The cash flow tax relinquishes tax at the

original payment source, creating uncertainty as to whether savers

ultimately will pay the tax due on consumption. Commentators have

voiced concerns that some individuals would never pay the delayed tax

due to expatriation or other tax evasion and avoidance mechanisms."

The cash flow tax also would shift significantly the imposition of the

progressive rate structure. The amount of wages for the year largely

determines the degree of progressivity under current law. Progressivity

under the cash flow tax would be based instead on the yearly

consumption level, thereby introducing significant new imprecision.8

To summarize, the cash flow tax changes go well beyond the

risk-free exemption demonstrated in Part I above. These additional changes

are unfortunate because they trigger serious objections-yet they are

unrelated to the consumption tax's loophole-closing virtue, which stems

from the risk-free exemption. Is it possible, then, to develop a different

consumption tax form which maintains the loophole-closing virtue

without raising the cash flow tax objections? As demonstrated in the next

Part, two innovative "dual" consumption taxes provide an affirmative

response.

III.

SIMILAR APPEAL OF THE

Two

DUAL CONSUMPTION TAXES

The preceding Part highlighted the objectionable tradeoffs of the

singular VAT and cash flow consumption taxes. This Part demonstrates

how the Hybrid Approach and the X-tax similarly avoid these

unacceptable offsets while preserving the consumption tax's

loophole-closing virtue. As shown below, the trick is to decompose the

consumption tax into multiple parts, consisting of a progressive wage tax

and a supplementary tax on consumption less wages. Neither the X-tax

nor the Hybrid Approach taxes consumption per se, as evidenced by

78. The prior problem recedes over time as transition savings are consumed.

79. E.g., Michael J. McIntyre, The Design of Tax Rules for the North American Free Trade

Alliance, 49 TAX LAW REV. 769, 769 n.14 (1994). The expatriation concern arises, for instance, because an expatriate would be outside the United States at the time of consumption. For a more detailed discussion of these issues, see Engler & Knoll, supra note 6, at 64-65; Engler, supra note 7.

8o. This follows from the fact that the tax collection date on saved wages would shift from the wage date to the consumption date. Setting aside the delay in the tax collection, the concern involves the possible change in tax rates on the two dates. Even in the absence of legislative change to the rate structure, a different tax rate could result due to the progressive rate structure. For instance, a higher tax rate could apply under the cash flow tax if consumption is bunched together into a heavy consumption year (e.g., the purchase of a home or transfers upon death to the extent wealth transfers were treated as consumption). See Alvin C. Warren, Jr., Fairness and a Consumption-Type or Cash

Flow Personal Income Tax, 88 HARV. L. REv. 931 (i975). For a more detailed discussion of these issues, see Engler & Knoll, supra note 6; Engler, supra note 7.

their similar taxation of saved wages. Nonetheless, both approaches end

up with the equivalent of a consump